Last week's flows were choppy due to the Federal Reserve meeting and the prior Friday's employment report. Most investors were sidelined, though servicers were actively selling and there was some profit taking by banks. In addition, there was selling from originators totaling slightly more than $1 billion per day on average, mostly in 5.5s and 6s. Over the week, spreads versus Treasurys on 30-year Fannie Mae 4.5s through 6.5s averaged 10 basis points wider. In 15s, spreads were 16 basis points weaker in 4s, plus 11 basis points in 4.5s, while 5s and 5.5s were seven and three basis points cheaper, respectively.

A rough period ahead for mortgages?

Near term, the going looks rough for the mortgage sector. According to analysts at Lehman Brothers, convexity hedging needs are substantial, which could push implied vols up in coming weeks. Analysts calculate that the duration of the MBS Index has extended by around $550 billion since mid-March so there are significant rebalancing needs in the market. JPMorgan Securities sees potential spread pressure as well from banks liquidating securities prior to Fed action with the intent to buy them back later at higher yields.

In comments from Countrywide Securities, analysts note that the continued sell-off is raising concerns about extension risk. However, Countrywide believes that investor fears of an event like last summer are overblown. This is because most of the extension in the active and liquid part of the market has already occurred. For example, the analysts calculate that at a 4.5% yield on the 10-year, the incremental MBS market extension for a 10 basis point increase in interest rates is around $23 billion in 10-year equivalents. At a 5% yield, it is $10 billion.

Another difference between now and last summer is the size of "fast money" positions in MBS. Dealer positions were at their largest levels in more than five-years last summer. Dealers are currently at around one-third of those levels so they weren't caught "painfully offside" in the latest downtrade like they were last year. Two potential concerns may be the GSEs and banks. Regarding the first issue, Countrywide suggests the GSEs are so large that they can be viewed to resemble the overall mortgage universe. In this context, their convexity needs should behave similarly to the overall market. In other words, their duration responses should decline as rates increase further from current levels.

With the Fed tightening, there is the potential for banks to reduce their MBS holdings as funding becomes more expensive. This would result in unwanted supply of MBS duration hitting the market at the wrong time, says Countrywide. However, the analysts believe bank deleveraging is more likely an issue with the larger institutions, which designate more of their holdings as available-for-sale versus the smaller institutions that tend to be more hold-to-maturity oriented.

Servicers are a concern as the increase in rates has exacerbated the negative convexity in their portfolios, says Countrywide. As a result, analysts warn that servicers could be net buyers of optionality in the weeks ahead, which could increase implied vols and cause mortgages to underperform in the near term.

While it looks like mortgage spreads will be pressured in the period ahead of actual Fed tightening, JPMorgan predicts tighter MBS spreads in six months primarily due to the favorable technicals.

Both Purchase and Refi Indexes rise

The Mortgage Bankers Association (MBA) reported an increase in mortgage application activity for the week ending April 30. The Purchase Index rose 4% to 483. This was expected following comments from Countrywide Securities that said that purchase activity remained strong last week. What was unexpected was the increase in the Refi Index to 2516 from 2403, a nearly 5% gain. Analysts had been expecting a slight decline given the increase in mortgage rates above 6%.

As a percentage of application activity, refinancings were unchanged at 44%, said the MBA. At the same time, ARM share was essentially unchanged at 32.1% compared with 32.7% previously.

Fixed mortgage rates rise more than expected

Freddie Mac reported further increases in mortgage rates for the week ending May 7. According to their survey, the 30-year fixed-rate mortgage rose 11 basis points to 6.12%. At the current level, rates are at their highest level since last September. Freddie Mac also reported that the 15-year rate stands at 5.47% versus 5.25% last week, a 12 basis point gain; the one-year ARM rate increased just one basis point to 3.76%.

Looking to next week's report, JPMorgan expects the Refi Index to hold above 2000 due to strong ARM activity.

Cashouts hold steady in first quarter

Freddie Mac reported that in the first quarter of 2004, 43% of Freddie-owned loans that were refinanced resulted in new loans that were at least 5% higher than the original loan amount. This compares with 44% in 4Q03 and 41% in 1Q03. According to Frank Notaft, Freddie Mac's chief economist, "the share of cashout refis tends to rise when overall refinancing activity slows down because fewer borrowers find it economical to refinance their mortgages simply for a lower rate but the cashout alternative may be a very affordable option."

The survey also reported that the median ratio of old-to-new interest rate was 1.22. This means that at least half of those who paid off their original loan took out a new one that had an interest rate that was 22% lower than the old rate. This was unchanged from the fourth quarter of last year.

In this release, Freddie Mac also began reporting a forecast of the total dollar value of equity extraction that will occur in 2004 based on the firm's estimate of refi activity in the prime, conventional market. The GSE estimates homeowner equity converted into cash was $23 billion for the quarter, and for the year it is predicted to be around $114 billion.

The median home price appreciation on refinanced properties was 6% since the original loan was made. This compares to 7% in the same period a year ago and 12% in the fourth quarter of 2003. The median age, meanwhile, was just over two years.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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